Risk management remains high on the agenda – UK investors continue to make use of liability-driven investment (LDI) strategies

UK pension schemes have reduced their equity exposure at the slowest rate since the financial crisis, according to Mercer’s annual European Asset Allocation Survey. The survey looks at the asset allocation of over 1,200 European pension funds with combined assets of over €850 billion. In the UK, where equity allocations have nearly halved in the last decade, the pace of exit has slowed from an average of four percentage points a year over the previous five years, to a mere two percentage point reduction over 2013. Across the rest of Europe, the average equity allocation was broadly flat over the year.

EUROPEAN ASSET ALLOCATION SURVEY: Pace Of Exit From Equities Slows As Sentiment Improves

Phil Edwards, European Director of Strategic Research for Mercer’s investment business, commented: “Perhaps counter-intuitively, the weak economic growth of the last few years has coincided with exceptionally strong equity markets. The rising market and improving sentiment are likely to have been the key supports to equity allocations over the last year, though there remains scant evidence of any ‘great rotation’ in institutional portfolios.

“Many markets have risen in response to the ultra-stimulative monetary policy pursued since 2009 – as a result, prospective returns are arguably uninspiring across a range of asset classes. We expect institutional investors to meet this challenge by responding more dynamically to changing market conditions and introducing a wider range of return drivers into portfolios.”

In stark contrast to retail investors, institutional investors have shown no sign of rushing out of emerging markets following the difficulties experienced by a number of emerging economies over the last 12 months. Almost half of the schemes surveyed have exposure to emerging market equities and almost a fifth have an allocation to emerging market debt, demonstrating a commitment to the long-term return potential of these markets.

Seeking diversification through alternatives

Alternative asset classes continue to gain traction with European investors – the proportion of European plans having an allocation to alternative assets rose from 44% to 53% over the last year. Real assets (such as property, infrastructure, agriculture and natural resources) are the most widely used category of alternative asset, with 41% of plans currently holding an allocation. Within property allocations, interest has shifted towards less traditional parts of the market such as long leases, debt and second-tier property (the latter being primarily a UK phenomenon).

Investors seeking a broadly diversified exposure to a range of asset classes, together with some degree of dynamic asset allocation, have, for some time, allocated to diversified growth funds (DGFs), with almost a fifth of all plans having an allocation to such a strategy. In a similar vein, multi-asset credit strategies (new to this year’s survey) are set to become a popular means of accessing a diversified portfolio of credit assets (including high yield debt, loans, structured credit, emerging market debt and convertibles) and incorporating some rotation across these areas over time.

Mr Edwards commented, “Multi-asset credit has been one of the recent beneficiaries of the continued move away from traditional benchmark-oriented credit mandates and we expect to see further activity in this area over the course of 2014. We have also seen continued manager search activity and an up-tick in allocations to private debt as institutional investors look to exploit the opportunities arising from bank deleveraging in Europe.”

Trends for the future

The long-term trend away from equities is set to continue over the next 12 months, with 28% of investors looking to reduce domestic equity allocations and a quarter suggesting they will reduce non-domestic equity allocations. At the same time, more than 20% of plans indicated that they intend to increase the allocation to bonds, with index-linked gilts, corporate bonds and matching assets expected to be the main areas of interest.

The proportion of plans making some use of LDI strategies has increased only modestly over the last year, from 26% to 29% of participants. Mr Edwards noted, “Despite the relatively small increase in the use of LDI strategies, the management of interest rate and inflation risk remains a high priority for pension plan trustees. The complexity and governance challenges around LDI may have acted as a barrier for smaller schemes in the past, but given the range of pooled and delegated LDI approaches now available, we expect to see the gap in take-up between large and small schemes reduce over time.”